Themes, outlook, and investment implications across global fixed income markets
Principal Fixed Income
Fixed income perspectives
Economic turning points
With the likelihood of a recession growing, the landscape for fixed income investors is shifting as we enter the third quarter of 2023
U.S. outlook
With the economy slowing, the labor market showing signs of better balance, generally resilient data, and gradually improving inflation, we find ourselves asking if the Federal Reserve (Fed) will successfully engineer a soft landing to this cycle after all. Perhaps the most reliable leading indicator of a recession is the yield curve or the difference between long- and short-maturity U.S. Treasury yields. Since 1970, only two of eight hiking cycles (present cycle excluded) have ended with a soft landing.
In both cases the curve did not invert. An inversion in the 3-month versus 10-year curve occurred in six of the eight cycles, and a recession followed each of those episodes. Not only is the 3-month versus 10-year curve currently inverted, but it is also as deeply inverted as it has been in over forty years.
Global outlook
The trend for global policymakers in aggregate is clearer; compared to the two previous quarters, fewer are hiking more, and more are hiking less – or not hiking at all. Policymakers recognize that policy actions taken so far will continue to have lagged, uneven transmission effects on their economies. Further, the recent banking crisis likely accelerated the tightening of credit conditions, giving policymakers more reason for a period of observation. This coming observation period will buy time for a slowdown in underlying growth to be better reflected in the data.
As monetary policy heads toward a pause, most asset classes will do well; however, historically, high-quality fixed income tends to deliver the most consistent returns on a risk-adjusted basis with lower variability. Attractive performance should continue well into the first-rate cuts, suggesting plenty of longevity for an overweight strategy in high-quality fixed income in this environment.
December 30, 2022
Number of economies (G20) hiking interest
As of May 25, 2023. Source: Bloomberg
The Group of Twenty (G20) is the premier forum for international economic cooperation. G20 comprises 19 countries (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, United Kingdom, and United States), and the European Union. The G20 members represent around 85% of the global GDP, over 75% of the global trade, and about two-thirds of the world population.
After raising policy rates 500 basis points over sixteen months, the end of the Federal Reserve’s hiking cycle is now within sight, shifting duration from headwind to a tailwind.
The forward-looking trend for global policymakers in aggregate has become clearer, with fewer hiking more, more hiking less, and some not hiking at all.
With several historically reliable economic indicators signaling that a recession is on the horizon, the stage is set for fixed income to perform well; particularly, high-quality assets.
High yield credit
Municipals
Investment grade credit
Securitized debt
Emerging
market debt
Private credit
Often, heightened volatility presages attractive buying opportunities across fixed income markets. That’s the scenario we find ourselves in at the end of 2022 within investment grade credit. The combination of higher yields and wider spreads, along with stable credit metrics, provides an attractive backdrop for corporate bonds.
We all knew the journey to higher rates was going to be damaging from a total-return standpoint; however, we believe most of the wreckage is behind us, and the magnitude of that movement in U.S. Treasury yields makes the anticipated path ahead promising as yields settle into a more range-bound band. In investing, after all, it matters more what we expect a security or asset class to do tomorrow than what it did yesterday.
Short AAA consumer asset-backed securities and government-guaranteed mortgage-baked securities offer attractive yields and tend to outperform into (and through) recessions.
Asset-backed securities have top credit ratings. And in many cases, they mature in just two or three years—providing cash-flow certainty for investors. Buying ABS amounts to a relatively short-term bet, and the price of the securities isn’t very sensitive to interest-rate changes. These factors make ABS attractive to investors during heightened market volatility.
We find agency MBS attractive. The asset class benefits from government guarantees of credit risk and little-to-no financing risk (even for a large rally in interest rates). MBS spreads have historically outperformed credit into a recession thanks to the government sponsorship of credit risk. MBS is poised to be the spread sector of favor as a recession nears.
As we look into 2023, much has changed in the high yield market over recent years that, in our opinion, should lead to a better outcome for the asset class if the highly anticipated recession comes to fruition. Since the global financial crisis, the credit-quality profile of the high yield market improved progressively and is now at record highs. Other positive factors ought to inform one’s view on high yield credit spreads, such as:
•Increasing levels of secured bonds
•Low default rates with minimal upcoming maturities
•Higher recoveries from defaults
All these currently paint a picture of fundamental strength for the asset class, which warrants historically tighter spreads. Even though spreads aren’t significantly wider over the last decade, the dollar price of high yield bonds is definitely below the average.
As we look into 2023, much has changed in the high yield market over recent years that, in our opinion, should lead to a better outcome for the asset class if the highly anticipated recession comes to fruition. Since the global financial crisis, the credit-quality profile of the high yield market improved progressively and is now at record highs. Other positive factors ought to inform one’s view on high yield credit spreads, such as:
•Increasing levels of secured bonds
•Low default rates with minimal upcoming maturities
•Higher recoveries from defaults
All these currently paint a picture of fundamental strength for the asset class, which warrants historically tighter spreads. Even though spreads aren’t significantly wider over the last decade, the dollar price of high yield bonds is definitely below the average.
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U.S. Zillow Rent Index, all homes, MoM
U.S. CPI Urban Consumers Owner Equivalent Rent of Residenes, SA
-0.50
0.00
0.50
1.00
1.50
2.00
Zillow rent index (MoM)
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
CPI owners equivalent rent (3m annual %)
2019
2020
2021
2022
Download full report (PDF)
Download full report (PDF)
Fixed income outlook, Q3 2023
High yield bonds vs. leveraged bank loans
Now is the time for investors to reassess return expectations and take a closer look at the relative value of high yield bonds vs leveraged bank loans.
2023 U.S. investment grade credit supply
As demand exceeds the supply of new debt, 2023 may shape up differently for Investment Grade markets.
Featured insights
Though public markets continued their year-end rally into 2023, opportunities remain attractive for investors in middle market private credit. Recessionary fears, high inflation, and public market volatility may cause investors to pause when considering an allocation to middle-market direct lending; however, we believe the loans originated during the current and upcoming period will deliver unique value. Having less cyclical industry exposure and generally lower leverage than the public market, the private middle market should offer the opportunity for attractive absolute/relative performance, as has been the case during many prior economic cycles and periods of market volatility.
Tightened lending standards by regional banks could prove favorable to deal volume, though most IG private placement issuers do not use the regional/super regional banks, relying instead on the too-big-to-fail lenders that are currently on solid footing. With expectations for the severity of a recession diminishing and the debt ceiling bill passed, we may start to see some compression in relative value in Q3, but enough uncertainty remains that any impact should be minimal.
Away from the epicenter of U.S. banking sector issues, emerging market debt (EMD) has traded relatively well in the context of the risk environment faced by developed markets. Both financial stresses faced by the asset class and EMD aggregate spreads are trading slightly above long-term averages.
While recovery is underway in China, momentum has lost steam relative to market expectations. Along with the new government and broader shifts in the economic structure, the lack of an immediate positive policy catalyst has made it more challenging for Chinese asset prices to find a strong basis for a clearer rebound. The moderating rebound in Chinese growth as well as the slowing growth in developed markets put pressure on commodities. The emerging markets commodity producers, that make the adjustments to focus less on hard commodity-related infrastructure and more on domestic consumption will be more suited to adapt to China rebalancing its economy.
With a U.S. debt default avoided in Q2, investors can once again pivot back to assessing the relative value proposition among various fixed income sectors. We believe municipals, when measured versus Treasurys or investment grade corporate debt, offer a compelling opportunity for tax-sensitive investors as we move into the second half of 2023.
Relative to Treasurys, municipals are offering some of the most attractive entry points in several months. A favorable technical backdrop that frames the asset class gives us confidence that municipals will reverse recent cheapening and outperform over the next several months.
The banking crisis in March 2023 had an unforeseen technical implication for agency mortgage-backed securities (MBS). Mortgage supply, which was improving dramatically due to lower/negative home price appreciation and reduced activity in the housing market, was suddenly forced to contend MBS passthroughs formerly held by Signature Bank and Silicon Valley Bank. Recent technical pressure in the sector represents opportunity for investors over the longer run.
Commercial mortgage-backed securities (CMBS) continue to trade significantly wider than similarly rated fixed income alternatives, reflecting stress in the office sector and a potential pull-back in bank lending. Investors are pricing in a high level of office stress alongside an elevated risk of recession, with so much risk “priced-in,” we believe opportunities exist for investors that can look deeper and perform real estate-driven security selection.
Short, high-quality consumer asset backed securities (ABS) offer a particularly attractive investment opportunity. The inverted yield curve and market technical factors have led to high benchmark yields and wide spreads. Expected credit trends remain well inside the performance envelope of ABS structures that have proven their resilience through multiple economic cycles. This combination should result in enticing all-in, risk-adjusted yields even if economic conditions deteriorate in the second half of the year.
We are in a stage of slowing global economies, softer earnings, and rising defaults. Our base case scenario is for widening credit spreads in the high-yield market, but this shouldn’t necessarily scare investors away from the asset class. The high yield sector offers attractive absolute and relative return prospects due to resilient corporate fundamentals, and high-yield leverage and interest coverage remain at their strongest levels historically. Although earnings have softened, most companies reported more beats than misses. Even assuming we see only modest spread widening, the elevated yield environment still generates attractive income and a reasonable total return.
Concerns – such as inflation, tighter central bank policy, and the potential for a global recession – remain, but issuer fundamentals and a receptive primary market provide support for high yield. We expect spreads to slightly widen from current levels, but with the starting yield around 9%, there is still potential for attractive total returns for the rest of 2023.
With spreads in the mid-130s, breakeven levels of nearly 20 bps appear compelling. Yields topping 5.4% remain attractive for would-be investors, as 60% of institutional investment grade buyers are yield-focused. Furthermore, a looming recession caused investors to stockpile cash, so there is plenty of it on the sidelines waiting to be deployed.
In the end, it boils down to fundamentals on one side of the lane and technicals on the other. While the former is weakening, the latter is strengthening. As the two forces play out, investment grade spreads will likely bounce back and forth.
Private credit
Emerging market debt
Municipals
Securitized debt
High yield credit
01
While challenges remain, including the growing threat of recession and continued economic volatility, expectations for softening economic data and a likely Fed rate policy shift should create opportunities in fixed income.
Investment implications
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U.S. Corporate Investment Grade
As of May 31, 2023. Source: Bloomberg.
U.S. Corporate High Yield 2% Issuer Cap Index
As of June 30, 2022. Source: Bloomberg U.S. Corporate High Yield Bond Index, Cliffwater Direct Lending Index, and S&P/LSTA Leverage Loan Index.
Sharpe ratio
(3Q 2004–2Q 2022)
COVID-19
(4Q 2019–1Q 2020)
Great recession
(2Q 2008–4Q 2008)
2.90
-5%
-8%
Direct
lending
0.37
-13%
-27%
High
yield
0.03
-13%
-30%
Syndicated
loans
CEMBI Broad Brazil STW
CEMBI Broad China STW
CEMBI Broad STW
Drawdowns
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Featured insights
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Featured insights
Q3 2023
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Fixed income
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Fixed income
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Looking beyond traditional LDI instruments as de-risking gathers steam
Defined benefit plans have patiently waited for the long-dated interest rate to rise. The time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets.
2023 U.S. investment grade credit supply
As demand exceeds the supply of new debt, 2023 may shape up differently for Investment Grade markets.
Get our perspective
Confidence crisis: Implications of bank failures on the industry
Bank failures have dominated the news, leaving many waiting for the next shoe to drop. Where do markets go from here?
Fixed income
•
5 min read
900
1000
1100
2.00
1.80
1.60
1.40
1.20
1.00
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0.40
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Title
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Muni-to-Treasury ratios
Get our perspective
Looking beyond traditional LDI instruments as de-risking gathers steam
Defined benefit plans have patiently waited for the long-dated interest rate to rise. The time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets.
Fixed income
•
7 min read
Title
As of May 31, 2023. Source: Bloomberg
U.S. Corporate High Yield 2% Issuer Cap Index
As of May 30, 2023. Source: J.P. Morgan. Dataquery, BofA Securities, Principal Real Estate. CMBS: On-the-Run BBB Index. Corporates: J.P. Morgan Developed Market HY 7-10 Index. Y-axis truncated to preserve scale; CMBS BBB spread hit 1,152 in April 2020.
CMBS BBB
Corporate high yield
1200
800
700
600
500
400
300
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
CMBS BBB and Corporate HY Spreads
As of May 30, 2023. Source Bloomberg.
86
Jan 17 Jan 31 Feb 14 Feb 28 Mar 15 Mar 31 Apr 14 Apr 28 May 15 May 31
BVAL AAA Muni Yield % of Treasury 30 Year (LHS)
As of June 1, 2023. Source: Bloomberg.
2
3
4
5
6
7
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
OFR Financial Stress Index Emerging Markets - Mid Price (RHS)
EM financial stress and spreads are trading just above long-term averages
Get our perspective
High yield bonds vs. leveraged bank loans
Now is the time for investors to reassess return expectations and take a closer look at the relative value of high yield bonds vs leveraged bank loans.
Fixed income
•
5 min read
MM 1st lien term loan yields (Direct Lenders only) (LHS)
MM 1st lien term loan yields (Banks + DL) (LHS)
Large corporate TY yields (LHS)
2013
2014
2021
As of March 31, 2023. Source: Refinitiv.
Above are the current views and opinions of Principal Global Investors and are not intended to be nor should they be relied upon in any way as a forecast or guarantee of future events regarding particular investments or the markets in general.
1st lien term loan (TL) yield and middle market (MM) yield premium, annual
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
Yield (%)
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Yield premium (%)
2020
2019
2018
2017
2016
2015
2022
Direct lenders MM yield premium
(over large corporate) (RHS)
MM yield premium (over large corporate) (RHS)
200
The forward-looking trend for global policymakers in aggregate has become clearer, with fewer hiking more, more hiking less, and some not hiking at all.
With several historically reliable economic indicators signaling that a recession is on the horizon, the stage is set for fixed income to perform well; particularly, high-quality assets.
March 31, 2023
May 25, 2023
-
1
2
3
4
5
6
7
8
9
10
paused or cut
0-50bp hike
50-100bp hike
>100bp hike
High
yield credit
Securitized
debt
Municipals
Emerging
market debt
Private
credit
View next:
High yield credit
High
yield credit
Securitized
debt
Municipals
Emerging
market debt
Private
credit
Investment
grade credit
Option adjustment spread (LHS)
Yield to worst (RHS)
View next:
Securitized debt
3%
5%
6%
8%
9%
11%
Yield to Worst
Aug 2020
As of May 31, 2023. Source: Bloomberg.
Fixed income
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7 min read
Fixed income
•
6 min read
Fixed income
•
5 min read
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The banking crisis in March 2023 had an unforeseen technical implication for agency mortgage-backed securities (MBS). Mortgage supply, which was improving dramatically due to lower/negative home price appreciation and reduced activity in the housing market, was suddenly forced to contend MBS passthroughs formerly held by Signature Bank and Silicon Valley Bank. Recent technical pressure in the sector represents opportunity for investors over the longer run.
Commercial mortgage-backed securities (CMBS) continue to trade significantly wider than similarly rated fixed income alternatives, reflecting stress in the office sector and a potential pull-back in bank lending. Investors are pricing in a high level of office stress alongside an elevated risk of recession, with so much risk “priced-in,” we believe opportunities exist for investors that can look deeper and perform real estate-driven security selection.
Short, high-quality consumer asset backed securities (ABS) offer a particularly attractive investment opportunity. The inverted yield curve and market technical factors have led to high benchmark yields and wide spreads. Expected credit trends remain well inside the performance envelope of ABS structures that have proven their resilience through multiple economic cycles. This combination should result in enticing all-in, risk-adjusted yields even if economic conditions deteriorate in the second half of the year.
View next:
Municipals
CMBS BBB and Corporate HY Spreads
Corporate high yield
CMBS BBB
Spread over USTs
200
As of May 30, 2023. Source: J.P. Morgan. Dataquery, BofA Securities, Principal Real Estate. CMBS: On-the-Run BBB Index. Corporates: J.P. Morgan Developed Market HY 7-10 Index. Y-axis truncated to preserve scale; CMBS BBB spread hit 1,152 in April 2020.
With a U.S. debt default avoided in Q2, investors can once again pivot back to assessing the relative value proposition among various fixed income sectors. We believe municipals, when measured versus Treasurys or investment grade corporate debt, offer a compelling opportunity for tax-sensitive investors as we move into the second half of 2023.
Relative to Treasurys, municipals are offering some of the most attractive entry points in several months. A favorable technical backdrop that frames the asset class gives us confidence that municipals will reverse recent cheapening and outperform over the next several months.
View next:
Emerging market debt
Muni-to-Treasury ratios
86
88
90
92
94
96
Jan 17
As of May 30, 2023. Source: Bloomberg.
BVAL AAA Muni Yield
% of Treasury 5 Year (RHS)
55
60
65
70
75
Feb 14
Mar 15
Apr 14
May 15
BVAL AAA Muni Yield
% of Treasury 10 Year (RHS)
BVAL AAA Muni Yield
% of Treasury 30 Year (LHS)
Away from the epicenter of U.S. banking sector issues, emerging market debt (EMD) has traded relatively well in the context of the risk environment faced by developed markets. Both financial stresses faced by the asset class and EMD aggregate spreads are trading slightly above long-term averages.
While recovery is underway in China, momentum has lost steam relative to market expectations. Along with the new government and broader shifts in the economic structure, the lack of an immediate positive policy catalyst has made it more challenging for Chinese asset prices to find a strong basis for a clearer rebound. The moderating rebound in Chinese growth as well as the slowing growth in developed markets put pressure on commodities. The emerging markets commodity producers, that make the adjustments to focus less on hard commodity-related infrastructure and more on domestic consumption will be more suited to adapt to China rebalancing its economy.
View next:
Private credit
EM financial stress and spreads are trading just above long-term averages
2
3
4
5
6
7
-0.5
0
0.5
1
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
0.154
3.5600
OFR Financial Stress Index Emerging Markets - Mid Price (RHS)
Bloomberg EM USD Aggregate Average OAS- Last Price (LHS)
As of June 1, 2023. Source: Bloomberg.
Though public markets continued their year-end rally into 2023, opportunities remain attractive for investors in middle market private credit. Recessionary fears, high inflation, and public market volatility may cause investors to pause when considering an allocation to middle-market direct lending; however, we believe the loans originated during the current and upcoming period will deliver unique value. Having less cyclical industry exposure and generally lower leverage than the public market, the private middle market should offer the opportunity for attractive absolute/relative performance, as has been the case during many prior economic cycles and periods of market volatility.
Tightened lending standards by regional banks could prove favorable to deal volume, though most IG private placement issuers do not use the regional/super regional banks, relying instead on the too-big-to-fail lenders that are currently on solid footing. With expectations for the severity of a recession diminishing and the debt ceiling bill passed, we may start to see some compression in relative value in Q3, but enough uncertainty remains that any impact should be minimal.
1st lien term loan (TL) yield and middle market (MM) yield premium, annual
4.00
9.00
10.00
11.00
12.00
13.00
0.00
0.50
1.00
1.50
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 1Q23
Large corporate TY Yields (LHS)
Direct lenders MM yield premium (over large corporate) (RHS)
As of March 31, 2023. Source: Refinitiv.
Above are the current views and opinions of Principal Global Investors and are not intended to be nor should they be relied upon in any way as a forecast or guarantee of future events regarding particular investments or the markets in general.
8.00
7.00
6.00
5.00
2.00
2.50
3.00
3.50
Yield (%)
MM Yield Premium (over large corporate) (RHS)
MM 1st Lien Term Loan Yields (banks + DL) (LHS)
MM 1st Lien Term Loan Yields Direct Lenders only) (LHS)
View last:
Emerging market debt
U.S. outlook
With the economy slowing, the labor market showing signs of better balance, generally resilient data, and gradually improving inflation, we find ourselves asking if the Federal Reserve (Fed) will successfully engineer a soft landing to this cycle after all. Perhaps the most reliable leading indicator of a recession is the yield curve or the difference between long- and short-maturity U.S. Treasury yields. Since 1970, only two of eight hiking cycles (present cycle excluded) have ended with a soft landing.
In both cases the curve did not invert. An inversion in the 3-month versus 10-year curve occurred in six of the eight cycles, and a recession followed each of those episodes. Not only is the 3-month versus 10-year curve currently inverted, but it is also as deeply inverted as it has been in over forty years.
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Power of the yield curve as measured by 3-month vs. 10-year curve
Hover over key to isolate data
0
5
10
15
20
-4.00
-2.00
0.00
2.00
4.00
6.00
1970-1974
1975-1979
1980-1984
1985-1989
1990-1994
1995-1999
2000-2004
2005-2009
2010-2014
2015-2019
2020-2024
3-month x 10-year curve (R)
Federal Funds rate (L)
Recession
3-month x 10-year inverts
As of April 30, 2023. Source: Bloomberg.
3-month x 10-year curve (R)
Federal Funds rate (L)
Recession
3-month x 10-year curve
Investment grade credit
02
03
04
05
06
Investment
grade credit
Jan 31
Feb 28
Mar 31
Apr 28
May 31
Yield Premium (%)
450
400
350
300
250
200
150
100
50
0
2021
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
U.S. Corporate Investment Grade
Option adjustment spread (LHS)
Yield to worst (RHS)
As of May 31, 2023. Source: Bloomberg.
Ratio (%)
300
400
500
600
700
800
900
1000
1100
1200
Spread over USTs
88
90
92
94
96
98
Ratio (%)
55
60
65
70
75
BVAL AAA Muni Yield % of Treasury 10 Year (RHS)
BVAL AAA Muni Yield % of Treasury 5 Year (RHS)
Bloomberg EM USD Aggregate Average OAS - Last Price (LHS)
-0.50
0.0
0.5
1.0
Title
11%
9%
8%
6%
5%
3%
Yield to Worst
Aug
2020
Title
2020
2022
2023
7%
6%
5%
4%
3%
2%
1%
0%
450
400
350
300
250
200
150
100
50
0
Title
7%
6%
5%
4%
3%
2%
1%
0%
Title
2020
2021
2022
2023
1Q23
Dec
2020
Apr 2021
Aug
2021
Dec
2021
Apr
2022
Aug
2022
Dec
2022
Apr
2023
Dec
2020
Apr
2021
Aug
2021
Dec
2021
Aug
2022
Dec
2022
Apr
2022
Apr
2023